Out of the Light, Into the Dark: How 'Shadow Carbon Financing' Hampers the Green Transition and Increases Climate-related Systemic Risk

Recent years saw major regulatory efforts to steer the financial system towards financing the transition to a net-zero carbon economy and phase out carbon financing. However, EU regulation focuses primarily on preventing greenwashing of retail funds and decarbonizing the banking system, while leaving the nexus of offshore finance and the shadow banking system untouched. These blind spots seriously undermine regulatory efficacy because offshore finance enables the obfuscation of financial flows, while shadow banking facilitates alternative financing to high carbon-emitting firms. Drawing on qualitative expert interviews and financial market data, the paper explains how the offshore-shadow-banking nexus hampers the green transition by introducing the concept of 'shadow carbon financing', which can operate through the following channels: (1) loan securitization, (2) emissions risk transfers, (3) bond financing, (4) carbon asset partitioning, (5) offshore corporate wealth chains, (6) private credit, and (7) proved developed producing reserves securitization. We demonstrate several instances of financial flows moving away from regulated and transparent forms of financing to less regulated and more opaque shadow carbon financing channels. Consequently, we argue that shadow carbon financing may also pose substantial systemic risk, as climate-related risks (e.g., stranded assets) increasingly accumulate in less regulated parts of the financial system.